WORKING CAPITAL MANAGEMENT 1.

Permanent or Fixed Working Capital: -

Permanent or fixed working capital is the minimum amount which is required to
INTRODUCTION: ensure effective utilization of fixed facilities and for maintaining the circulation of current
assets. There is always a minimum level of current assets which is continuously required by
The term Working Capital also called gross working capital refers to the firm’s the enterprise to carry out its normal business operations.
aggregate of Current Assets and current assets are these assets which can be convertible
2. Temporary or Variable Working Capital: -
into cash within an accounting period, generally a year Therefore, they are Cash or mere
cash resources of a business concern. We can say that the working capital is the firm’s Temporary or variable working capital is the amount of working capital which is
current assets or the excess of current assets over current liabilities. However, the later required to meet the seasonal demands and some special exigencies. Variable working
meaning will be more useful in most of the times as in all cases we may not find excess of capital can be further classified as seasonal working capital and special working capital.
current assets over current liabilities. The capital required to meet the seasonal needs of the enterprise is called
MEANING: seasonal working capital.
Special working capital is that part of working capital which is required to meet
Basically, working capital means the excess of current assets over current special exigencies.
liabilities. But, in this chapter, there are so many concepts of working capital. We can learn
so many concepts here such as Gross Working Capital, Net Working Capital etc. IMPORTANCE OR ADVANTAGES OF ADEQUATE WORKING CAPITAL:

DEFINITION: 1. Solvency of the business:

Adequate working capital helps in maintaining solvency of the business by
According to Accounting Standards Board, The Institute of Chartered Accountants providing uninterrupted flow of production.
of India, “Working capital means the funds available for day-to-day operations of an 2. Goodwill:
enterprise. It also represents the excess of current assets over current liabilities including
short-term loans”. Sufficient working capital enables a business concern payment and hence helps in
creating and maintaining goodwill.
CONCEPTS OF WORKING CAPITAL: 3. Easy loans:
A. Balance Sheet Concept A concern having adequate working capital, high solvency and good credit
There are two interpretations of working capital under the balance sheet concept: standing can arrange loans from banks and others on easy and favorable terms.
i. Quantitative or Gross Working Capital: - It refers to ‘total of current assets.’ Current 4. Cash discounts:
assets are considered to be gross working capital in this concept. Adequate working capital also enables a concern to avail cash discounts on the
ii. Qualitative or Net Working Capital: - It refers to “excess of current assets over purchases and hence it reduces costs.
current liabilities.” 5. Regular supply of raw materials:
B. Operating Cycle or Circular Flow Concept:
Funds invested in current assets keep revolving fast and are being constantly Sufficient working capital ensures regular supply of raw materials and continuous
converted into cash and this cash flows out again in exchange for other current production.
assets. Hence, it is also known as revolving or circulating capital. The circular flow 6. Regular payment of salaries, wages and other day-to-day commitments:
concept of working capital is based upon operating or working capital cycle of a firm. A company which has ample working capital can make regular payment of
The gross operating cycle of a firm is equal to the length of the inventories and salaries, wages and other day-to-day commitments which raises the morale of its
receivables conversion periods. Thus, Gross Operating Cycle = RMCP+WIPCP+ FGCP + RCP employees, increases their efficiency, reduces wastages and costs and enhances
Where; production and profits.
RMCP = Raw Material Conversion Period WIPCP = Work-in-Process Conversion Period 7. Exploitation of favorable market conditions:
FGCP Finished Goods Conversion Period RCP Receivables Conversion Period
Only concerns with adequate working capital can exploit favorable market
However, a firm may acquire some resources on credit and thus defer payments for certain
conditions such as purchasing its requirements in bulk when the prices are lower and
period. In that case, net operating cycle period can be calculated as below:
by holding its inventories for higher prices.
Net Operating Cycle Period = Gross Operating Cycle Period - Payable Deferral period
8. Ability to face crisis:
CLASSIFICATIONS OR KINDS OF WORKING CAPITAL:
Adequate working capital enables a concern to face business crisis in emergencies
such as depression because during such periods, generally, there is much pressure on
Kinds of Working working capital.
Capital FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS:

1. Nature and size of the Business:

A company’s working capital requirements depends on the activities it carried on
On the Basis of On the Basis of and its size too. For instance, public utility organisation or service organisation where
concept Time
 its activities are of mere service nature, does not require high amount of working production process may be hampered. It will reduce the sales and consequently the
capital. profitability of the business will be adversely affected.
2. Production Policies:
These policies will have a great significance in determining the size of the working Following are the disadvantages of excess working capital:
capital. Where production policies are designed in such a way that uniform production a. Excess working capital causes more inventory. As a result, chances of theft and misuse
is carried on throughout the accounting period, such concern requires a uniform and of stock increases.
lesser amount of working capital or vice-versa. b. Possibility of delay in realization of debt increases. It causes an increase in bad debts.
3. Process of Manufacture: c. Excess working capital increases speculation in stock by management. Management
If the manufacturing process of a particular industry is longer due to its complex follows liberal dividend policies. It can cause difficulties in future.
nature, more working capital is required to finance that process, because, longer the Inadequate working capital has following disadvantages:
period of manufacture, the larger the inventory tied up in the process. a. It puts at rest the development of the firm because due to inadequate working capital
4. Growth and Expansion of Business: management is unable to implement the profitable projects.
A business concern at status requires a uniform amount of working capital as b. In absence of adequate working capital, fixed assets cannot be utilized fully. As a result,
against the concerns which are growing and expanding. It is the tendency of any return on investment decreases.
business organisation to grow further and further till its saturation point, if any. Such c. Management cannot take advantage of business opportunities.
growth may be within the existing units by increased activities. d. The production process stops due to lack of raw material. Decrease in stock of finished
5. Fluctuations in the Trade Cycle: goods causes loss of sales.
e. Due to inability to pay short-term liabilities in time, goodwill of the firm is adversely
Business activities vary according to the general fluctuations in the world. There affected.
are four stages in a trade cycle which affects the activities of any business concern.
Accordingly, the requirements of working capital are bound to change. SOURCES/FINANCING OF WORKING CAPITAL:
6. Terms and conditions of Purchases and Sales:
A. Permanent or Fixed working capital requirements.
A business concern which allows more credit to its customers and buys its
B. Temporary or Variable working capital requirements.
supplies for cash requires more amount of working capital. On the other hand, business
concerns which do not allow more credit period to its customers and seek better credit PERMANENT OR FIXED WORKING CAPITAL REQUIREMENTS.
facilities for their supplies naturally require lesser amount of working capital. 1. Shares:
7. Dividend Policy:
Issue of shares is the most important source for raising the permanent or long-
A consistent dividend policy may affect the size of working capital. When some term capital. A company can issue various types of shares as equity shares and
amount of working capital is financed out of the internal generation of funds such affect preference shares. Preference shares carry preferential rights in respect of dividend at a
will be there. The relationship between dividend policy and working, capital is well fixed rate and in regard to the repayment of capital at the time of winding up the
established and very few companies declare dividend. company. Equity shares do not have any fixed commitment charge and the dividend on
8. Price Level Changes: these shares is to be paid subject to the availability of sufficient profits. As far as
The changes in prices make the functions of a finance manager difficult. The possible, a company should raise the maximum amount of permanent capital by the
anticipations of future price level changes are necessary to avoid their effects on issue of shares.
working capital of the firm. a. Equity Shares:
9. Operating Efficiency: Equity shares, also known as ordinary shares or common shares,
represent the owners' capital in a company. The holders of these shares are the
The Operating efficiency of a firm relates to its optimum utilization of resources real owners of the company.
available whether in any form of factor of production, say, capital, labour, material, b. Preference Shares:
machines etc. If a company is able to effectively operate its costs, its operating cycle is These shares are given two preferences. There is a preference for
accelerated and requires relatively lessor amount of working capital. payment of dividend. The second preference for these shares is the repayment of
10. Percentage of Profits and Appropriation out of Profits: capital at the time of liquidation of company.
The capacity of all the firms will not be same in generating their profits. It is 2. Debentures:
natural that some firms enjoy a dominant and monopoly positions due to the quality of A debenture is an instrument issued by the company acknowledging its debt to its
its products, reputations, goodwill etc. holder. It is also an important method of raising long-term or permanent working
EXCESS AND INADEQUATE WORKING CAPITAL capital. The debenture-holders are the creditors of the company. A fixed rate of interest
is paid on debentures. The interest on debentures is a charge against profit and loss
Business should maintain sound position of working capital. The amount of account.
working capital should neither be too excessive, nor too much inadequate. The working Types of Debentures
capital in excess of the requirement will reduce profitability as the funds will remain (a) Simple, Naked or Unsecured Debentures:
unutilized. Contrarily, if the amount of working capital is less than what it is required, the
 These debentures are not given any security on assets. They have no priority as Financial institutions such as Commercial Banks, Life Insurance Corporation,
compared to other creditors. They are treated along with unsecured creditors at the Industrial Finance Corporation of India, State Financial Corporations, State Industrial
time of winding up of the company. Development Corporations, Industrial Development Bank of India, etc. also provide
(b) Secured or Mortgaged Debentures: short-term, medium-term and long-term Joans. This source of finance is more suitable
These debentures are given security on assets of the company. In case of default to meet the medium-term demands of working capital. Interest is charged on such
in the payment of interest or principal amount, debenture holders can sell the assets loans at a fixed rate and the amount of the loan is to be repaid by way of instalments in
in order to satisfy their claims. a number of years.
(c) Bearer Debentures:
These debentures are easily transferable. The debentures are handed over to the TEMPORARY OR VARIABLE WORKING CAPITAL REQUIREMENTS
purchaser without any registration deed. Anybody purchasing them with a
1. Indigenous Bankers
consideration and in good faith becomes the lawful owner of the debentures. The
coupons for interest are attached to the debentures. The bearer can get interest from Private money-lenders and other country bankers used to be the only source of
the company' bank when it becomes due. finance prior to the establishment of commercial banks. They used to charge very high
(d) Registered Debentures: rates of interest and exploited the customers to the largest extent possible. Now-a-days
As compared to bearer debentures which are transferred by mere delivery, with the development of commercial banks they have lost their monopoly. But even
registered debentures require a procedure to be followed for their transfer. Both the today some business houses have to depend upon indigenous bankers for obtaining
transfer and the transferee are expected to sign a transfer voucher. loans to meet their working capital requirements.
(e) Redeemable Debentures: 2. Trade Credit
These debentures are to be redeemed on the expiry of a certain period. The Trade credit refers to the credit extended by the suppliers of goods in the normal
interest on the debentures is paid periodically but the principal amount is returned course of business. The trade credit arrangement of a firm with its suppliers is an
after a fixed period. The time for redeeming the debentures is fixed at the time of important source of short-term finance. The credit-worthiness of a firm and the
their issue. confidence of its suppliers are the main basis of securing trade credit. It is mostly
(f) Irredeemable Debentures: granted on an open account basis
Such debentures are not redeemable during the life time of the company. They The main advantages of trade credit as a source of short-term finance include:
are payable either on the winding up of the company or at the time of any default on (i) It is an easy and convenient method of finance.
the part of the company. The company can retain the right to redeem these (ii) It is flexible as the credit increases with the growth of the firm.
debentures after giving due notice to the debenture holders. (iii) It is informal and spontaneous source of finance.
(g) Convertible Debentures: However, the biggest disadvantage of this method of finance is charging of higher
Sometimes convertible debentures are issued by a company and the debenture prices by the suppliers and loss of cash discount.
holders are given an option to exchange the debentures into equity shares after the 3. Instalment Credit
lapse of a specified period.
(h) Zero Interest Bonds/Debentures: This is another method by which the assets are purchased and the possession of
Zero interest bond is an instrument recently introduced in India by some goods is taken immediately but the payment is made in instalments over a pre-
companies. It is usually a convertible debenture which yields no interest. The determined period of time. Generally, interest is charged on the unpaid price or it may
company does not pay any interest on such debentures. be adjusted in the price. But, in any case, it provides funds for some time and is used
3. Public Deposits: as a source of short-term working capital by many business houses which have difficult
fund position.
Public deposits are the fixed deposits accepted by a business enterprise directly 4. Advances
from the public. Now-a-days even long-term deposits for 5 to 7 years are accepted by
the business houses. Public deposits as a source of finance have a large number of Some business houses get advances from their customers and agents against
advantages such as very simple and convenient source of finance, taxation benefits, orders and this source is a short-term source of finance for them. It is a cheap source of
trading on equity, no need of securities and an inexpensive source of finance. The finance and in order to minimize their investment in working capital, some firms having
Reserve Bank of India has also laid down certain limits on public deposits. Non-banking long production cycle, especially the firms manufacturing industrial products prefer to
concerns cannot borrow by way of public deposits more than 25% of its paid-up capital take advances from their customers.
and free reserves. 5. Factoring or Accounts Receivable Credit
4. Ploughing Back of Profits: Another method of raising short-term finance is through accounts receivable
Ploughing back of profits means the reinvestments by concern of its surplus credit offered by commercial banks and factors. A commercial bank may provide
earnings in its business. It is an internal source of finance and is not suitable for an finance by discounting the bills or invoices of its customers. Thus, a firm gets
established firm for its expansion, modernization and replacement etc. This method of immediate payment for sales made on credit. A factor is a financial institution which
finance has a number of advantages as it is the cheapest rather cost-free source of offers services relating to management and financing of debts arising out of credit
finance; there is no need to keep securities; there is no dilution of control; it ensures sales.
stable dividend policy and gains confidence of the public. At present, factoring in India is rendered by only a few financial institutions on a
5. Loans from Financial Institutions: recourse basis.
6. Accrued Expenses
 Accrued expenses are the expenses which have been incurred but not yet due (vi) Fixed Letter of Credit. It fixes the amount of financial obligation of the issuing bank
and hence not yet paid also. These simply represent a liability that a firm has to pay for either in one bill or in several bills put together.
the services already received by it. The most important items of accruals are wages
and salaries, interest, and taxes. Wages and salaries are usually paid on monthly, DISTINGUISH BETWEEN SHARES AND DEBENTURES:
fortnightly or weekly basis for the services already rendered by employees. The longer
the payment-period, the greater is the amount of liability towards employees or the Basis Shares Debentures
funds provided by them. 1. Nature A share is a part of owned capital. A debenture is an
7. Deferred Incomes acknowledgement of a debt.
2. Pay out Shareholders are paid dividend Debenture holders are paid
Deferred incomes are incomes received in advance before supplying goods or
on the shares held by them. interest on debentures.
services. They represent funds received by a firm for which it has to supply goods or
3. Rate The rate of dividend depends A fixed rate of interest is paid on
services in future. These funds increase the liquidity of a firm and constitute an upon the amount of divisible debentures irrespective of profit
important source of short-term finance. However, firms having great demand for its profits and policy of the Board of or loss.
products and services, and those having good reputation in the market can demand Directors.
deferred incomes. 4. Accounting Dividend on shares is a charge Interest on debentures is a charge
8. Commercial Paper Treatment against Profit and Loss against Profit and Loss account
Commercial paper represents unsecured promissory notes issued by firms to raise Appropriation account.
short-term funds. It is an important money market instrument in advanced countries 5. Voting Shareholders have voting rights. Debenture holders doesn’t have
Rights They have control over the voting rights.
like U.S.A. In India, the Reserve Bank of India introduced commercial paper in the Indian
management of the company.
money market. Only a company which is listed on the stock exchange, has a net worth
6. Status They are the owners of the Debenture holders are only
of at least 10 crores and a maximum permissible bank finance of 25 crores can issue
company. creditors of the company.
commercial paper not exceeding 30 per cent of its working capital limit.
7. Time period Shares are not redeemable (with Debentures can be redeemed
Commercial paper is a cheaper source of raising short-term finance as compared the exception of redeemable after a certain period.
to the bank credit and proves to be effective even during period of tight bank credit. preference shares) during the life
9. Working Capital Finance By Commercial Banks of the company.
Commercial banks are the most important source of short-term capital. The major 8. Priority At the time of liquidation of the Debentures are payable in priority
portion of working capital loans are provided by commercial banks. They provide a wide company, share capital is payable over share capital.
variety of loans tailored to meet the specific requirements of a concern. after meeting all outside
liabilities.
The different forms in which the banks normally provide loans and advances are
as follows:
(a) Loans (b) Cash Credits (c) Overdrafts (d) Purchasing and OPERATING CYCLE
Discounting of bills. Working Capital is also termed as circulating or revolving capital. Capital invested in
current assets keep fast revolving and it is being converted into cash constantly. Thus, cash
LETTER OF CREDIT flows out again and again in exchange for other current assets. In this way, the circular
flow of working capital is based on the operating cycle of a business concern.
A letter of credit popularly known as L/c is an undertaking by a bank to honour the
obligations of its customer up to a specified amount, should the customer fail to do so. It
The operating cycle is the total duration taken to complete one cycle of operation, te., the
helps its customers to obtain credit from suppliers because it ensures that there is no risk
time it takes to turn the cash into raw materials and then back into cash (through collection
of non-payment.
from debtors). For manufacturing firms, operating cycle consists of three activities:
A letter of credit may be of many types, such as:
A. Procurement of raw material.
(i) Clean Letter of Credit. It is a guarantee for the acceptance and payment of bills without
B. Transformation of raw material into finished goods.
any conditions.
C. Selling of finished goods.
(ii) Documentary Letter of Credit. It requires that the exporter's bill of exchange be
accompanied by certain documents evidencing title to the goods. 
(iii) Revocable Letter of Credit. It is one which can be withdrawn by the issuing bank
without the prior consent of the exporter.
(iv) Irrevocable Letter of Credit. It cannot be withdrawn without the consent of the
beneficiary.
(v) Revolving Letter of Credit. In such type of letter of credit, the amount of credit it
automatically reversed to the original amount after such an amount has once been paid as
per defined conditions of the business transaction. There is no need for further application
for another letter of credit to be issued provided the conditions specified in the first credit
are fulfilled.
 CASH FLOW STATEMENT 8. Assist in Dividend Decisions:
Since dividend is to be paid within 42 days of its declaration, the management
INTRODUCTION & MEANING: needs cash flow statement beforehand to ascertain the magnitude of cash.

Cash Flow Statement is a statement that explains how cash and cash LIMITATIONS OF CASH FLOW STATEMENT:
equivalents held by the business have changed between one balance sheet date and the
1. Ignores Non-cash Transactions:
next one. Cash Flow Statement reveals the causes of changes in cash position of business
concern between two dates of Balance Sheets. Cash flow statement ignores the non-cash transactions In other words, it does not
According to Accounting Standard - 3 (Revised) an enterprise should consider those transactions which do not affect the cash e.g., issue of shares against
prepare a Cash Flow Statement and should present it for each period with financial the purchase of fixed assets, conversion of debentures into equity shares, etc.
statements prepared. 2. Not a Substitute for Statement of Profit and Loss:
ELEMENTS OF CASH FLOW STATEMENT: It is not a substitute for Statement of Profit and Loss. Net cash flow disclosed by
cash flow statement does not necessarily mean net income of the business, because
AS-3 (Revised) has also given the meaning of the words cash, cash net income is determined by taking into account both cash and non-cash items.
equivalent and cash flows: - 3. Not Suitable for Judging the Profitability:
(i) Cash: This includes cash on hand and demand deposits with banks.
Cash flow statement is not suitable for judging the profitability of a firm as non-
(ii) Cash equivalents: Cash Equivalents are short term, highly liquid investments that are
cash charges are ignored while calculating cash flows from operating activities.
readily convertible into cash. This includes purely short term and highly liquid
4. Manipulation of Cash Position:
investments which are readily convertible into cash and which are subject to an
insignificant risk of changes in value. The management may manipulate the cash position. Better cash position may be
(iii) Cash flows: This includes inflows and outflows of cash and cash equivalents. If the as a result of postponing the payments, which will have to be made through at a later
effect of transaction results in the increase of cash and its equivalents, it is called an date.
inflow (source) and if it results in the decrease of total cash, it is known as outflow (use 5. Not based on Full Information:
of cash). Cash flow statement does not present true picture of the liquidity of a firm.
OBJECTIVES OF CASH FLOW STATEMENT: Liquidity does not depend upon 'cash' alone. Liquidity, also affected by the assets
which can be easily converted into cash.
1. Determine Cash Flows:
CLASSIFICATION OF CASH FLOWS:
It ascertains cash inflows and/or outflows arising from operating, investing, and/or
financing activities. According to AS-3 (Revised) cash flows are classified into three main categories:
2. Determine Change in Cash and Cash Equivalents: A. Cash flows from Operating Activities.
B. Cash flows from Investing Activities.
It indicates the difference between sources and uses from or by the operating,
C. Cash flows from Financing Activities.
investing, and/or financing activities between two succeeding Balance Sheet dates.
3. Aid in Preparation of Cash Budget: A. CASH FLOWS FROM OPERATING ACTIVITIES:

When we prepare cash budget on the basis of projected cash flow statement for Operating activities are the principal revenue-producing activities of the
future, the management is informed about surplus or deficit of cash. enterprise and other activities that are not investing or financing activities.
4. Provide Efficient Cash Management: The amount of cash flows arising from operating activities is a key indicator of the
extent to which the operations of the enterprise have generated sufficient cash flows to
effective cash management, surpluses may be planned for short-term maintain the operating capability of the enterprise, pay dividends, repay loans, and make
investments while proper arrangements may be made for periods of deficits to obtain new investments without recourse to external sources of financing.
credit in advance. Cash Inflows from Operating Activities
5. Assist in Short-term Financial Planning:
1. Cash receipts from sales of goods and rendering services.
Since cash flow statement contains information for specific periods, it helps 2. Cash receipts from royalty, fees, commissions and other revenues.
management to plan for short-term operating, investing, and/or financing activities. At 3. Receipt from debtors and bills receivable.
large, cash flow also guides overall business planning. 4. Cash refunds of income taxes unless they can be specifically identified with financing or
6. Submit Systematic Study of Cash Receipts and Payments: investing activities.
Cash flow statement reveals the rate at which funds are generated through 5. Cash receipts from insurance enterprises through claims and settlement of policies, etc.
current assets and the speed with which they are used to pay off current liabilities. This Cash Outflows from Operating Activities
offers the management a true insight into the cash position of future.
1. Cash payments to suppliers of inputs and services used.
7. Formulate Historical Analysis:
2. Cash payments to and on behalf of employees for wages, salaries, etc.
Evaluation of financial decisions taken in the past can be done through cash flow 3. Payment to creditors and Bills payables.
statement. It provides ready answers to uses of cash obtained in time periods in 4. Cash payments of income taxes unless they can be specifically identified with financing
question or trace their availability. or investing activities.
5. Cash payments 8. Sale of marketable securities for cash at par;
9. Declaration of final dividend₹25,000;
B. CASH FLOWS FROM INVESTING ACTIVITIES:
10. Writing off bad debts against the provision for doubtful debts;
Investing activities are the acquisition and disposal of long- term assets and other 11. Declaration of Interim Dividend;
investments not included in cash equivalents. The separate disclosure of cash flows arising 12. Sale of Current Investments;
from investing activities is important because the cash flows represent the extent to which 13. Increase in Bank Overdraft; and
expenditures have been made for resources intended to generate future income and cash 14. Decrease in Cash Credit.
flows.
Cash Inflows from Investing Activities ANSWER
1. Cash receipts from disposal of fixed assets including intangibles. 1. Inflow: - Cash is increased by ₹45,000.
2. Cash receipts from sale of shares, warrants or debt instruments of other enterprises 2. Outflow: - Cash is decreased by the amount of purchase of Stock-in-trade
and interest in joint ventures, etc. 3. No flow: - Cash is not transacted
3. Cash receipts from the repayment of loans and advances made to third parties. 4. Inflow: - Cash is increased by ₹10,000.
4. Cash receipts of insurance claim for property involved in accident. 5. No Flow: - It is a movement between two components of Cash and Cash Equivalents
5. Cash receipts of interest and dividend. 6. No flow: - It is a movement between two components of Cash and Cash Equivalents.
Cash Outflows from Investing Activities 7. No Flow: - Cash is not affected. It is capitalization of profits
8. No Flow: - Cash which includes marketable securities also is not affected
1. Cash payments to acquire fixed assets including intangible assets such as goodwill, 9. Outflow: - Declaration of final dividend means shareholders have approved the
patents and copyrights. It also includes payment made to construct fixed assets. dividend. Declared dividend is paid within 30 days of declaration.
2. Cash payments to purchase shares, warrants or debt instruments of other enterprises, 10. No Flow: - Cash is not affected.
investment in joint ventures, etc. 11. Outflow: - Interim dividend declared is paid within 30 days of declaration
3. Cash advances and loans made to third parties (other than loans and advances made 12. No Flow: - Current Investments are part of Cash and Cash Equivalents
by a financial enterprise 13. Inflow: - Short-term Borrowing has increased.
C. CASH FLOWS FROM FINANCING ACTIVITIES: 14. Outflow: - Short-term Borrowing has decreased.

Financing activities are activities that result in changes in the size and QUESTION
composition of the owner’s capital (including Preference Share Capital in the case of a
company) and borrowing of the enterprise. The separate disclosure of cash flows arising State which of the following would result in inflow or outflow of Cash and Cash Equivalents:
from financing activities is important because it is useful in predicting claims on future cash 1. Sale of Plant and Machinery (book value ₹1,50,000 at a loss of ₹15,000,
flows by providers of funds (both capital and borrowing) to the enterprise. 2. Purchase of Stock-in-Trade for cash;
Cash Inflows from Financing Activities 3. Purchase of Building by issue of shares;
4. Cash received from debtors ₹1,20,000;
1. Cash proceeds from issuing shares or other similar instruments. 5. Cheque deposited into Bank;
2. Cash proceeds from issuing debentures, loans, notes, bonds and other short-term or 6. Cash withdrawn from Bank;
long-term borrowings. 7. Issue of fully paid bonus shares;
Cash Outflows from Financing Activities 8. Investment in Marketable Securities (short term)
9. Writing off bad debts against the provision for doubtful debts,
1. Cash repayment of amounts borrowed.
10. Declaration of final dividend.
2. Cash payments for Buy-back of equity shares.
3. Cash payments for redemption of preference shares. METHODS OF CALCULATING CASHFLOWS: -
4. Cash payments for dividend on equity and preference shares.
5. Cash payments for interest on debentures. There are two methods of reporting cash flows from operating activities namely
6. Cash payments for interest on loans 2) Direct Method and
3) Indirect Method.
ILLUSTRATION A. The Direct Method:
State which of the following would result in inflow or outflow of cash and cash Under the direct method, cash receipts (inflows) from operating revenues and
equivalents with reason; cash payments (outflows) for operating expenses are calculated to arrive at cash
1. Sale of fixed assets (Book value₹50,000) at a loss of ₹ 5,000; flows from operating activities. The difference between the cash receipts and cash
2. Purchase of Stock-in-Trade for cash; payments is the net cash flow provided by (or used in) operating activities.
3. Purchase of fixed assets against issue of shares;
4. Cash received from debtors₹10,000; Format of Cash Flow Statement (Under Direct Method):
5. Cash deposited into Bank;
6. Cash withdrawn from Bank; AMT
AMT.
7. Issue of fully paid bonus shares; PARTICULARS .
 CASH FLOWS FROM OPERATING ACTIVITIES PARTICULARS AMT. AMT.
Cash receipts from customers *** CASH FLOW FROM OPERATING ACTIVITIES
Cash paid to suppliers and employees (***) ***
Net profit before tax and extraordinary items
Cash generated from operations ***
(***) Add: Non-cash and non-operating items which have already been
Income tax paid
debited to P.L. Account
Cash flow before extraordinary items ***
(a) Depreciation ***
Extraordinary items ***
(b) Transfer to reserves and provisions ***
Net cash from (used in) Operating activities ***
(c) Good will written off ***
(Or)
(d) Preliminary expenses written off ***
Net profit before tax and extraordinary items ***
Adjustments for non-cash and non-operating items (Depreciation,
(e) Other intangible assets written off such as discount or loss on ***
Foreign Exchange Loss, Loss on Sale of assets, Interest Income, ***
issue of shares / debentures, underwriting commission etc.
Dividend etc,)
(f) Loss on sale or disposal of fixed assets ***
Operating profit before working capital changes ***
*** (g) Loss on sale of investments ***
Adjustments for changes in current assets and current liabilities
Cash generated from (used in) operations before tax *** (h) Foreign exchange loss *** ***

Income tax paid ***

Less: Non-cash and non-operating items which have already been
Cash flow before extraordinary items *** credited to P.L. Account
Extraordinary items (such as refund of tax) *** (a) Gain on sale of fixed assets ***
Net Cash from (used in) Operating activities *** (b) Profit on sale of investments ***

(c) Income from interest or dividends on investments ***

CASH FLOWS FROM INVESTING ACTIVITIES ***
(d) Appreciation
Individual items of cash inflows and outflows from financing activities ***
(e) Reserves written back ***
(Such as purchase/sale of fixed assets, purchase or sale of *** (f) Foreign exchange gain ***
investments, interest received, dividend received etc.
***
Net cash from (used in) investing activities ***
Operating Profit Before Working Capital Changes

CASH FLOWS FROM FINANCING ACTIVITIES Adjustments for changes in current operating assets and liabilities:
Individual items of cash inflows and outflows from financing activities ***
Add: Decrease in Accounts of Current Operating Assets (except cash
(such as) proceeds from issue of shares, long-term borrowings, and cash equivalents) such as:
repayments of long- term borrowings, interest paid, dividend paid *** ***
Decrease in trade debts ***
etc.)
Net increase (decrease) in cash and cash equivalents *** Decrease in bills receivables ***

Cash and cash equivalents at the beginning of the period ***

Add: Increase in accounts of current operating liabilities (except
Cash and cash equivalents at the end of the period *** Bank overdraft) such as:
Increase in creditors ***
B. The Indirect Method:
Increase in bills payable *** ***
Under the indirect method, the net cash flow from operating activities is
determined by adjusting net profit or loss for the effect of: ***
a. Non-cash items such as depreciation, provisions, deferred taxes, and unrealized Less: Increase in accounts of current operating assets (as stated
***
foreign exchange gains and losses; above)
b. Changes during the period in inventories and operating receivables and payables. Less: Decrease in accounts of current operating liabilities (as stated
*** ***
c. All other items for which the cash effects are investing or financing cash flows. above)
Format of Cash Flow Statement (Under Indirect Method): Cash generated from (used in) operations before tax ***
 Less: Income tax paid *** Cash Flow Statement is based on Funds Flow Statement is based
2. Based On
*** cash basis of accounting. on accounting.
Cash flows before extraordinary items
Add / Less: Extraordinary items if any *** In the case of Funds Flow
3. Changes No such schedule of changes in
*** Statement, a schedule of
Net cash flow from (used in) operating activities in Working working capital is prepared for a
changes in working capital is
Capital Cash Flow Statement.
prepared.
CASH FLOWS FROM INVESTING ACTIVITIES
*** Cash Flow Statement as a tool of
Individual items of cash inflows and outflows from financing activities Funds Flow Statement is useful
4. financial analysis is more useful
in planning, Intermediate and
Usefulness for short-term analysis and cash
(Such as purchase/sale of fixed assets, purchase or sale of *** long-term financing.
planning.
investments, interest received, dividend received etc.
Net cash from (used in) investing activities ***
Cash Flow Statement is prepared Funds Flow Statement reveals
by taking into consideration the the sources and application of
CASH FLOWS FROM FINANCING ACTIVITIES 5. Objectives inflows and outflows in terms of funds. The difference represents
Individual items of cash inflows and outflows from financing activities *** operating, investing and financing net increase or decrease in
(such as) proceeds from issue of shares, long-term borrowings, activities. working capital.
repayments of long- term borrowings, interest paid, dividend paid *** ***
etc.) Funds Flow Statement deals
6. Cash Flow Statement deals only
with all components of working
Net increase (decrease) in cash and cash equivalents *** Components with cash and cash equivalents.
capital.
Cash and cash equivalents at the beginning of the period ***

Cash and cash equivalents at the end of the period *** 

NEED OF PREPARING CASH FLOW STATEMENT:

1. Cash Flow Statement reveals the causes of changes in cash balances between two
Balance Sheet dates.
2. This statement helps the management to evaluate its ability to meet its obligations
i.e., payment to creditors, the payment of bank loan, payment of interest, taxes,
dividend etc.
3. It throws light on causes for poor liquidity in spite of good profits and excessive
liquidity in spite of heavy losses.
4. It helps the management in understanding the past behavior of cash cycle and in
controlling the use of cash in future.
5. Cash Flow Statements helps the management in planning repayment of loans,
replacement of assets etc.
6. This statement is helpful in short-term financial decisions relating to liquidity.
7. This statement helps the management in preparing the cash budgets properly.
8. This statement helps the financial institution who lends advances to business
concerns in estimating their repaying capacities.
9. Since a Cash Flow Statement is based on the cash basis of accounting it is very useful
in evaluation of cash position of a firm.
DIFFERENCES BETWEEN FUNDS FLOW STATEMENT AND CASH FLOW STATEMENT:

Basis Cash Flow Statement Funds Flow Statement

Funds Flow Statement reveals
Cash Flow Statement reveals the
the change in working capital
1. Nature changes in cash position between
between two Balance Sheet
two balance sheet dates.
dates.